From Fed pivot to Fed pause

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Good morning. On a day when Donald Trump was sued for fraud and Vladimir Putin called up extra troops, all anyone in finance could talk about was the Federal Reserve. We join in, below. Email us: [email protected] and [email protected]

The Fed

The Fed’s summary of economic projections (SEP) for September looked very different from the last one, released three months ago. At a high level of abstraction, the change is not surprising. The new SEP just put into words the bluntly and emphatically hawkish message from chair Jay Powell in, for example, his Jackson Hole speech a month ago. But words leave more room for interpretation, and therefore misunderstanding, than numbers do.

There were three particularly big changes:

  • 2022 GDP growth was downgraded from 1.7 per cent to 0.2 per cent. 2023 got a half-point haircut to 1.2 per cent.

  • The projected policy rate for year-end 2023 was upgraded from 3.8 per cent to 4.6 per cent — a shade higher than the 4.5 per cent peak policy rate the futures market had anticipated would arrive for the middle of that year.

  • The 2023 unemployment projection went from 3.9 per cent to 4.4 per cent.

This is meaty stuff, and consistent with the repeated message of yesterday’s press conference, which was that rates are not just going to be high, but are going to be high for long enough to hurt. A taste:

Over the next three years, the median unemployment rate [projection] runs above the median estimate of its longer-run normal level . . . The historical record cautions strongly against prematurely loosening policy . . . Reducing inflation is likely to require a sustained period of below-trend growth and it will very likely be some softening of labour market conditions . . . We’ll need to bring our funds rate to a restrictive level and to keep it there for some time.

And so on. Judging by the market reaction, it was all a touch more hawkish than expected. The futures market nudged its expectations for the peak policy rate, and pushed the peak out from March to May. The bond market took it all in stride, with a little move up in the short end and a little move down in the long end (tougher policy today, lower inflation tomorrow). The stock market didn’t like the show much; the S&P 500 fell 1.7 per cent. But it’s hard to read much into that move in a market that had loads of downward momentum coming in.

There do remain two important disconnects between the Fed’s projections and what the market expects, however.

The futures market is looking for a policy rate of 4.2 per cent at the end of next year; the Fed is looking for 4.6. That’s big: it appears that the market expects core inflation to fall enough in the next 12 months for the Fed to start cutting. The Fed thinks otherwise.

But take Powell at his word. Speaking of the rate projections yesterday, he said that they “do not represent a committee decision or plan, and no one knows where the economy will be a year or more from now”. That’s the fact, Jack. The Fed’s projections don’t say, here is what we will do. They say, here is what we are prepared to do, if core inflation stays above 3 per cent. Whether or not core inflation does that, well, your guess is quite literally as good as theirs.

The second disconnect is more substantive. The SEP projects unemployment to rise 0.6 percentage points between the end of 2022 and the end of 2023, to 4.4 per cent. This is significant. One well-known recession indicator, the Sahm Rule, starts blinking red after a move in unemployment of 0.5 percentage points or more over a 12-month period. At the same time, though, the SEP calls for GDP to grow a non-recessionary 1.2 per cent in 2023. A lot of pundits (Unhedged included) can’t figure out how these two things fit together.

Here, for example, is Andrzej Skiba of RBC Global Asset Management:

We struggle to understand how the Fed expects unemployment to move upwards and rates head beyond 4.5 per cent, while US growth remaining in 1.2-1.7 per cent range in 23-24’. We think that with rates now expected to peak meaningfully above 4 per cent US recession next year is likely.

RBC does not struggle alone. Here is Aneta Markowska of Jefferies:

Unemployment has never increased by more than 0.5 per cent without causing a recession, so the FOMC is betting that time is different . . . since it’s extremely unlikely that the Fed’s forecast comes to fruition, we see little value in the FOMC’s rate projections beyond next year.

But even if you think the Fed is too optimistic about the chances of the soft landing, it would be foolhardy to doubt its commitment to keep raising rates — to say nothing of cutting them — until it sees much better inflation data and significantly tighter financial conditions. Rick Rieder of BlackRock points out, rightly, that the next step is not a Fed pivot, but a Fed pause:

The question today, then, becomes how close are we to a policy resting place, whereby the Fed could wait for restrictive policy to work its way through the economy over coming months, allowing the now famous “long and variable lags” to tamp down inflation

How close to that are we? Powell made a telling comment in the press conference that “we believe that we need to raise our policy stance overall to a level that is restrictive” and that, among other things, this means “you would see positive real rates across the yield curve and that is an important consideration”.

How close are we to positive real rates across the board? At the short end of the rates spectrum, an intuitive way to see this is to look at the real policy rate, that is, the federal funds rate minus the Fed’s preferred inflation measure, core personal consumption expenditure. A fed funds rate at zero plus surging inflation pushed the real policy rate down rapidly. We are still in negative territory, but there has been a major change in trajectory (and the Fed foresees more of the same).

At the middle and long end of the curve, real rates are in positive territory if you use inflation-protected Treasuries, or nominal Treasuries less survey inflation expectations, as the benchmark. Subtracting core PCE from nominal Treasuries, however, still renders a negative real rate. Core PCE is running at 4.6 per cent annually, and the 10-year Treasury is at 3.5. Don’t count on a Fed pause, much less a pivot, until that gap is far tighter. (Armstrong & Wu)

One good read

Was anyone actually cooking their chicken in NyQuil?

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